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- QUESTION
- How has Diageo managed its capital structure? Do you agree it is conservative?
Using the data provided by the simulation model presented in the case and your personal assessment, what capital structure would you recommend to Diageo, more or less debt than it currently has? For this question, the quantitative part is already provided by the case (see Figure 2 in the case). Thus, you should take the numerical results in the case as yours, and thus draw your own conclusions in order to respond (no need to review the Monte Carlo description). While it may seem trivial (a reading of the graph), you can also suggest modifications resulting in higher or lower leverage levels than those recommended by the simulation.
Diageo plc Ian Cray, Diageo plc’s Treasurer, looked out of his office window onto the busy streets of London in October 2000. The London-based consumer goods company Diageo had recently announced its intention to sell its packaged food subsidiary, Pillsbury, to General Mills. Earlier in the year, Diageo also announced its intent to sell 20% of its Burger King subsidiary through an initial public offering during 2001, to be followed by a spin-off of the remainder of Burger King after December 2002. If these transactions took place, the firm would be focused exclusively on the beverage alcohol industry. As Diageo’s business was restructured, it was an opportune time to rethink its financing mix. On Cray’s desk lay a novel report by Ian Simpson, Diageo’s Director of Corporate Finance and Capital Markets, and Adrian Williams, the firm’s Treasury Research Manager. Their analysis sought to quantify the textbook characterization of the tradeoff between the costs and benefits of different gearing, or leverage, policies. Built around a simulation model of the future cash flows of the company, their analysis attempted to understand the tax benefits of higher gearing versus the likelihood and severity of costly financial distress. While the analysis was still rough at points, the concepts and implementation were intriguing. Now that Diageo was rethinking its financial policies, the model could prove useful. Simpson, Williams and Cray would soon meet to discuss its implications. Diageo’s Business Diageo was formed in November 1997 from the merger of Grand Metropolitan plc and Guinness plc, two of the world’s leading consumer product companies. The newly-merged firm was the seventh largest food and drink company in the world with a market capitalization of nearly £24 billion and annual sales of over £13 billion to more than 140 countries. The merger was ostensibly motivated by the desire to become the industry leader and expected cost savings of nearly £290 million per year due to marketing synergies, reduction in head office and regional office overhead expenses, and production and purchasing efficiencies. Some investors had been critical of the merger. One equity analyst, who judged that the firm would underperform the market, wrote “Diageo is creating an entity that fails to learn from all the mergers and acquisitions in other consumer areas that found portfolio strength does not work.”1 Separately, Bernard Arnault, the CEO of LVMH, a French luxury goods and drinks company, tried to scuttle the deal, and replace it with a three way merger that included LVMH while “demerging” Pillsbury and Burger King. Arnault, already the largest shareholder, doubled his stake to 11% of the combined stock, but failed to change the terms of the merger. 1 J. Wakely, A. Gowen, R. Newboult, F. Ramzan, “Diageo,” Lehman Brothers, November 21, 1997. For the exclusive use of N. Almoammer, 2015. This document is authorized for use only by Naif Almoammer in Corporate Finance - DEM4 at Hult International Business School, 2015. 201-033 Diageo plc 2 While Diageo’s name was not well known to the average consumer, its brands were among the most famous in the world. The firm was organized along four business segments. The largest was the Spirits and Wine business, which produced and marketed a portfolio of beverage alcohol such as scotch, vodka, gin, and tequila. Diageo’s brands included Johnnie Walker, Smirnoff, J&B, Bailey’s, Gordon’s, Tanqueray, Cuervo, and Malibu. This division was not only the biggest (with revenues of £5 billion and the leading market share in the U.S. and U.K. markets) but also the fastest growing of Diageo’s businesses, with sales growth of 8% for the year. More than 70% of sales and sales growth came from the Europe and North America markets. This segment enjoyed the largest profit margins of all of the segments, with 15% operating margins and growth in total operating profits of 15%. The high levels of operating profits reflected Diageo’s strategy of concentrating on premium brands and pricing. (Exhibits 1 and 2 contain historical financial information for Diageo and its business segments.) Diageo’s second largest division was Guinness Brewing, which produced and sold beer to markets around the world. This segment, while substantially smaller in sales than the Spirits and Wine Division, was a close second to it in terms of operating profit growth rate. Due to the similarity in the products and distribution channels for these two businesses, Diageo was in the process of integrating them, which might result in cost reductions of £130 million annually. Diageo’s two remaining businesses were in packaged and fast foods. Its Pillsbury subsidiary was a leading producer of packaged food products. Its brands included Progresso, Green Giant, and Haagen Dazs. Diageo’s fourth and smallest business segment was its Burger King subsidiary, which had sales of £941 million. Burger King operated a series of fast-food restaurants throughout the world, though the bulk of revenues came from North America. Since the 1997 merger, Diageo’s stock price performance had lagged versus broad market indices. (See Exhibit 3.) In September 2000, Paul Walsh, who had previously been the CEO of the Pillsbury subsidiary, was named the Group Chief Executive of Diageo. Walsh’s new strategy involved focusing on “beverage alcohol, driving growth through innovation around our unrivalled portfolio of brands and providing an improved base for sustained profitable top line growth.” To achieve this goal, Diageo agreed to sell Pillsbury to General Mills. Under the proposal, General Mills would pay Diageo $5.1 billion in cash plus 141 million newly issued shares of General Mills stock. The shares were worth approximately $5.4 billion and would result in Diageo owning approximately 33% of the new General Mills/Pillsbury business. In addition, Diageo management announced their intention to exit the fast food business through an initial public offering of Burger King. Walsh stated in July that ”We are going to develop the option first of all to float 20 percent of Burger King. Then after 2002, we will potentially float the balance of 80 percent. … We can float 20 percent now without triggering a significant tax charge. There are tax regulations that say after 2002 we should be able to float the balance without incurring any taxes.”2 With these actions, Diageo would concentrate solely on the beverage alcohol business. Continued growth could come from organic growth or from potential acquisitions. “Organic growth” might involve increased sales of existing products or product extensions, such as Smirnoff Ice, a blend of Vodka and lemon juice or a new bottled version of Guinness. On-going capital expenditures to support organic growth as well as to modernize existing production facilities was projected to require about £ 400 - 500 million per year for the next five years. Growth could also come from acquisitions, but the amount that Diageo might need was virtually impossible to estimate with much certainty. It was unclear which firms Diageo might be able to acquire, which other firms might bid for them, how much rival bidders might be able and willing to spend, and how hotly contested the bidding might become. Diageo’s major rivals in the alcoholic beverage industry, such as Bacardi, Allied Domecq, Seagrams and Pernod Ricard were not only potential rival bidders for firms and brands, but potential acquisition targets themselves in the consolidating beverage alcohol business. For example, Seagram’s beverage unit was up for sale in autumn of 2000 and analysts guessed it might fetch $7 to 9 billion. Diageo was working on a joint bid for Seagrams with Pernod Ricard, which 2 Bloomberg News Service, June 22, 2000. For the exclusive use of N. Almoammer, 2015. This document is authorized for use only by Naif Almoammer in Corporate Finance - DEM4 at Hult International Business School, 2015. Diageo plc 201-033 3 might commit Diageo to spend $3 to 5 billion. Smaller private firms and individual brands were also considered potential acquisition candidates at the right price. In an “expansion scenario,” Diageo might spend as much as $6 to 8 billion for acquisitions in the next three years including Seagram’s; a “minimalist” scenario might involve very little acquisition, and a “midrange” estimate was about $2.5 billion over five years. These were not official Diageo forecasts, but rather very rough guesses by the finance team. (See Exhibit 4 for comparable companies.) As part of its focus on shareholder value, Diageo was also an active seller of brands that did not fit into its growth strategy.3 In general, Diageo sought to be in a strong position to expand its beverage spirits business. While Diageo was already the world’s largest beverage spirits firm, acquisitions could be integrated into its system, allowing Diageo to enjoy certain efficiencies and synergies. These benefits could arise from cost savings in manufacturing, procurement and supply, or through savings in the distribution system and an enhanced ability to reach consumers. Acquisitions might be important in light of the industry consolidation, among both suppliers and distributors, in the alcoholic beverage business. It was therefore critical for the finance side of the business to be able to fund these opportunities, if and when they arose. Diageo’s Historical Capital Structure In general, British firms tended to have more conservative financial policies than firms in other nations. Research showed that the book value of equity accounted for 42% of the total assets of the average UK firms (excluding financial service firms), as compared with 28% to 40% in other highly developed nations.4 Both Guinness and Grand Metropolitan used reasonably little debt to finance themselves prior to the creation of Diageo. (See Exhibit 1.) This policy choice was reflected in the relatively high ratings on the bonds of the two firms, AA and A, respectively.5 Rating agencies, like Standard and Poor’s and Moody’s, assigned ratings to bonds to reflect the company’s ability to make promised interest and principal payments on its debt. When Guinness and Grand Met announced their merger, the companies were put on Credit Watch by one of the rating agencies due to the uncertainty about their new financial policies.6 When the companies merged, management chose to retain the policies of the merged companies, in part to maintain the status quo, and in part because the policy “felt right.” While Diageo could have increased its debt and let its debt rating fall to BBB (one level below its current A rating), the feeling was that this “seemed a bit risky.” They also felt that there had been an implicit promise to the public when the individual companies had previously issued bonds. Diageo communicated its decision to investors and rating agencies in the merger announcement by stating “The enlarged group's policy will be to manage actively the capital 3 For example, Diageo sold Dewar’s Scotch whiskey and Bombay Gin to Bacardi for 1.2 billion pounds in early 1998. Approximately 500 million pounds of the cash payment was paid out to shareholders under the B-share program that began in February 1998. The 320 million pounds remaining after taxes went to pay down debt. Souce: The Financial Post, March 31, 1998. 4 R. Rajan and L. Zingales, “What Do We Know about Capital Structure? Some Evidence from International Data.” The Journal of Finance, 50, (December 1995) 1421-1460. The study examined firms in the G-7 countries (the seven countries with the largest economies) which included United States (with 34% equity as a percentage of assets), Japan (33%), Germany (28%), France (31%), Italy (33%), and Canada (40%). The calculation measured the book value of equity divided by total assets for each firm listed in the Global Vantage database. 5 Debt ratings were generally broken down into two classes, Investment Grade (IG) and Non-Investment Grade (NIG). IG consists of debt with S&P ratings of BBB- and higher, while NIG were BB+ and lower. While many of the differences between individual ratings were small, NIG credits were considered to have significantly more risk and lower market liquidity for a few reasons. First, the higher credit risk required more time and expertise to value, and investors demanded higher promised returns. Second, regulations prohibited many institutional investors (such as money market mutual funds) from owning low-rated debt. Consequently, there was less money available to make the investments, shrinking the size of the market and reducing the bidding competition for the offered debt instruments. Together, these effects reduced the amount of money that weaker credits could raise, and increased the interest expense. 6 A firm is placed on “CreditWatch” when it is exposed to material specific events or short term trends that need special attention to evaluate, such as mergers, recapitalizations, voter referendums, regulatory action, or anticipated operating developments. A listing does not guaranty that the rating will change. For the exclusive use of N. Almoammer, 2015. This document is authorized for use only by Naif Almoammer in Corporate Finance - DEM4 at Hult International Business School, 2015. 201-033 Diageo plc 4 structure so as to keep the interest cover ratio, in normal circumstances, within a band of five to eight times.”7 Once the merger was complete and policies disclosed, the rating agencies confirmed that the firm’s debt would be rated A+, the rough average of the two predecessor firms. Credit rating agencies use a long list of quantitative and qualitative factors to establish the creditworthiness of firms. The Treasury team, however, found that the firm’s interest coverage ratio was probably a critical variable that determined its rating. Interest coverage was measured as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) divided by Interest Payments. The Treasury team felt that Diageo could maintain its credit rating of A+ by maintaining interest coverage of 5 to 8 times. This was lower than required in some other industries to obtain an A+ rating, in part due to the stable nature of Diageo’s portfolio of brands. (As a secondary target, they sought to keep EBITDA divided by Total Debt at about 30 to 35%.) If the firm’s coverage were to fall below 5, it would risk a downgrade. The firm adjusted its coverage ratio in a lumpy fashion through a combination of debt issuance, repurchases and other large transactions. Figure 1, taken from an internal Diageo presentation, shows the firm’s interest coverage over time, and the actions the firm took. The strong debt rating afforded considerable benefits for Diageo in the capital markets. In general, the highest rated firms (known as Investment Grade firms) were able to raise financing more readily and paid lower promised yields than firms with weaker ratings. (See Exhibits 5 and 6.) The additional yield that lower-rated firms needed to pay on their debt (the credit yield spread) was calculated and reported widely. However, limitations on lower-rated firms’ abilities to borrow were less well measured. The capital markets for highly rated international firms like Diageo were relatively deep. When the Treasury team was asked to speculate on its ability to raise funds, they guessed that as an A-rated borrower, they could probably raise additional debt of $8 billion in 12 months while maintaining the rating. If Diageo were rated BBB, it might be able to raise $5 to 8 billion, and if they were rated BB they could raise less than $5 billion over the same time. These were very rough unofficial estimates, which might vary over time. (In comparison, Diageo speculated that if their competitors were willing to sell assets and risk a credit rating downgrade, their two largest could each raise maybe $9 billion over this time, two others might be able to raise $3-4 billion each, and a fifth $2-2.5 billion.) An additional benefit of a high rating was the ability to access short-term commercial paper borrowings at attractive rates. Short-term interest rates available through the commercial paper8 (CP) market were up to 25 basis points below the London InterBank Offer Rate (LIBOR), a rate that large banks quoted for short term unsecured loans. For comparison, the interest rate that A rated companies paid on 5-year bonds was typically LIBOR + 40 basis points, or 0.65% higher than the CP rates. Lower rated firms found it difficult to raise money in the commercial paper market, as this was an unsecured form of borrowing. Furthermore, the major holders of commercial paper (money market funds) were prohibited by regulation in holding more than 5% of their portfolios in low-rated short-term funds. Approximately 47% of Diageo’s debt, about 3.2 billion pounds, was issued as short-term commercial paper with maturities of 6 months to one year. If Diageo’s long-term debt were to be rated BBB, its ability to raise commercial paper might be severely limited. The Corporate Treasury’s Simulation-Based Model One of Diageo’s core philosophies, inherited from Grand Metropolitan, was the idea of “Managing for Value,” a variant of “Economic Value Added.” The idea was relatively simple - the return earned by a division should cover not only its operating expenses, but also the cost of the capital employed by the division.9 While the mandate for Managing for Value came from the highest levels of Diageo, the 7 Bloomberg News Service. 8 Commercial paper is an unsecured promissory note, typically maturing within 270 days. 9 Diageo instituted the philosophy through the bonus plan, which applied to the top three ranks of managers, more than 1400 people in all. The plan was uncommon in three aspects. First, the bonus pool was benchmarked against the capital charges incurred For the exclusive use of N. Almoammer, 2015. This document is authorized for use only by Naif Almoammer in Corporate Finance - DEM4 at Hult International Business School, 2015. Diageo plc 201-033 5 Treasury team was charged with establishing the cost of capital for each of the 110 countries in which the firm operated. This was a very difficult task that kept them focused on calculating the pros and cons of various financing policies. In December 1998, the Treasury team retreated to Drummuir, a resort in Scotland, to brainstorm about Diageo’s financial policies. In particular, the staff considered new approaches in finance and rethought which treasury functions should be centralized, what the firm’s risk footprint should be, how to calculate the cost of capital, and how to optimally structure the firm’s balance sheet. One of the more novel discussions revolved around the firm’s funding policies. Finance textbooks and MBA programs often taught that a firm’s gearing should reflect the tradeoff between the tax benefits of debt (modeled as tax shields) and the costs of financial distress. While the tax deductibility of interest on debt was easily modeled (Diageo’s composite marginal tax rate was 27%) the costs of financial distress were more elusive. Textbooks depicted graphs of the stylized tradeoff between the tax shields and costs of financial distress, but it was much more difficult to examine this tradeoff rigorously in practice. A long line of academic research attempted to measure the costs of financial distress. Financial difficulties gave rise to direct costs, including the costs for legal and financial advisors. Financial distress could also lead to indirect or strategic costs in three ways. First, competitors could attempt to take advantage of the situation by increasing their market share (for example by starting a price war with the hope that the distressed firm just collapses). Second, customers might be less willing to purchase from the distressed firm, especially if the purchases are long-term in nature and might require future support (for example, warranty repairs). Third, management might focus on the financial crisis and not running the business, and the firm might forgo profitable investments for future cash flow. Recent research that quantified the average value loss of distressed firms influenced the Treasury team's thinking.10 This data gave an indication of the cost of financial distress, but not its likelihood. Simpson and Williams now felt they had most of the information they needed to roughly quantify the implications of the tradeoff between tax shields and the costs of distress. In order to do this, they would need to calculate their tax shields each year, as well as whether Diageo would get into financial distress in each year. To evaluate the likelihood of financial distress, they would have to model the firm’s cash flow generation over time, over a broad range of market conditions. A thorough review of historical results, as well as an audit by outside consultants, found that Diageo’s operating cash flow or return on assets, as measured by EBIT/assets,11 was driven by the fluctuations in sales and exchange rates. They calculated the historical time series of profitability by segment for Diageo as well as for a sample of comparable firms. (See Exhibit 7.) This distribution of profitability, especially for the beverage alcohol business, would give them some information on the future distribution of profitability. In general, all of Diageo’s businesses, including the beverage alcohol business which it would retain, had relatively stable cash flows, which had allowed Diageo to take on a higher level of debt than other companies. Financial distress was determined by the financial policies of the company - in particular by its level of gearing and by the maturity of the debt it issued. (Interest payments on Diageo’s short-term debt would be affected by interest rates.) With broad probability distributions and multiple by a division. Second, negative bonuses could be earned (penalized) when the capital charges were not covered. Finally, bonuses were paid into a “bonus bank” with a claw-back provision. Every year, an employee’s bonus would be “paid” to his or her account. One-half of the balance was paid out immediately. The other half was held in escrow against potential future negative bonuses. This kept managers focused on long-term performance while meeting short-term goals. 10 See T. Opler, M. Saron, and S. Titman, “Designing Capital Structure to Create Shareholder Value.” Journal of Applied Corporate Finance, 10 (1), Spring 1997, 21-32, and T. Opler, S. Titman, “Financial Distress and Corporate Performance,” Journal of Finance, 49 (3), July 1994, 1015-1040. Over the period 1972-1991, the research studied industry-adjusted change in sales, operating income, and market value of highly levered firms in industries experiencing downturns. Industry downturns were defined as drops in sales and market values of 30% or greater. After controlling for industry performance, the studies found that as highly levered firms lost an additional 14%, 12% and 7% of sales, operating income, and market value relative to the average firm in the industry, and 26%, 27% and 15% more than the least levered firms in their industry. 11 Depreciation and amortization in this industry were relatively low, so EBIT and EBITDA were similar. For the exclusive use of N. Almoammer, 2015. This document is authorized for use only by Naif Almoammer in Corporate Finance - DEM4 at Hult International Business School, 2015. 201-033 Diageo plc 6 gearing policies to consider, Simpson and Williams turned to Monte Carlo simulation analysis to help guide the process. Monte Carlo analysis was a technique that physicists developed to help build the first nuclear weapons during the latter stages of the Second World War. This form of simulation was used to quantify uncertainty when the underlying problem was difficult or impossible to solve exactly, for example when key parameters are random variables, and to understand the final distribution of outcomes, not just the expected value. Operating cash flow, exchange rates and interest rates changed over time in a hard-topredict fashion, and financial distress was a low probability, high significance “non-linear” event. The simulation technique was a statistical analysis of multiple experiments or “trials.” Each trial represented the results from one “realized” set of random draws of the different input variables. By keeping track of the output of each trial as well as the summary statistics, the user could construct a more precise distribution for the expected variability of the underlying model. Simpson and Williams used spreadsheet programs to simulate the present value of taxes paid and financial distress costs paid, across a set of gearing policies. For each trial, earnings (EBIT) as a percentage of assets were forecast, by year, as a function of three uncertainties: the return on assets for each geographical region, the currency exchange rates, and the interest rate paid on the firm’s debt. Separately for each gearing policy, the model calculated the interest rate (as a rating-dependent credit spread over a base rate), and the total interest that the company would pay every year. The earnings and interest determined both the taxes paid, and the interest coverage ratio for the current period. The interest coverage ratio, in turn, established the current period debt rating. Diageo was assumed to be in financial distress when the interest coverage ratio was less than one. Economically, this was equivalent to a firm EBIT less than the interest payments, or that the firm would have to borrow money (or draw down reserves) to meet its debt obligations. A distress condition imposed a one-time permanent 20% reduction in the value of the firm. There was no provision in the model for issuing equity to pay down debt when coverage fell. However, when the interest coverage was too high, the firm issued a special dividend to “regear” itself back to the targeted coverage range.12 The model assumed a constant year-end zero cash balance. An excess cash flow that the business generated (i.e., EBIT – interest – taxes – total dividends) was used to pay down the outstanding debt, while new debt was issued to finance a cash shortfall. Otherwise, assets were assumed to grow at the current interest rate. (See Exhibit 8 for a simplified flow chart of the analysis.) Each trial was a 15-year sequence, which kept track of the firm's operating cash flows, interest payments, coverage, and distress on a semiannual basis. In any one trial, the firm might enjoy large tax shields from levering up, but never get into trouble. For some trials, however, the firm’s cash flows might dip low enough to trigger distress and a 20% reduction in asset value. The model was run for 10,000 trials. Each trial calculated the present value of taxes paid and the cost of financial distress for each of the different debt policies. Once all trials were completed, the model generated statistical expectations for total tax paid and costs of financial distress under each of the different policies. See Figure 2 for the summary diagram from the analysis, which shows the average tax bill and costs of financial distress under a variety of interest coverage policies. The Capital Structure Decision Cray looked again at the value trade-off chart from the Monte Carlo analysis. Simpson and Williams had completed much of the analysis under the previous treasurer, so he could look at their work with fresh eyes. It was an interesting analysis that had the potential to help shape the capital structure of the restructured Diageo. However, he needed to make sure that it was robust enough to bring to attention of the Group Finance Director, Nick Rose, and ultimately to the Board of Directors. He reflected on his own 12 The model included regular dividend payments, which could be cut if cash flow after interest and tax payments were not large enough. Diageo’s dividend policy was considered important to investors, and it was thought that the firm would have cut other expenditures, such as marketing or capital expenditures, or borrowed money, before cutting the dividend. For the exclusive use of N. Almoammer, 2015. This document is authorized for use only by Naif Almoammer in Corporate Finance - DEM4 at Hult International Business School, 2015. Diageo plc 201-033 7 concerns: He had always defined financial distress as “being unable to meet the expectations of the bondholders and equity holders of the firm.”13 He had spent a great deal of time making sure that firm’s financial policies provided enough flexibility for Diageo to carry out its core strategy. Further, he appreciated that the firm had flexibility in some of its operating areas; for example, in times of stress, perhaps the firm would “tinker” with its £1 billion advertising budget. Cray wondered how these concerns might affect his interpretation of the analysis, and what he should recommend as the financial policy for Diageo looking forward.
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Answer
- How has Diageo managed its capital structure? Do you agree it is conservative?
To best appreciate how Diageo managed its capital structure, it is important to understand its origins. Diageo was formed by the coming together of Grand Metropolitan and Guinness. Both this companies adopted and pursued a conservative capital structure. Indeed, both had leverage ratios that were significantly below the industrial average. At its emergence, the new organization made it a priority to let it be known that it would be maintaining the same policies with regards to debt management as the previous companies had. It thus based its decision on the trade-off theory which proposes and supports that organisations needs to pursue an optimal structure that best balances tax benefits thereof with expected distress costs. Analysis of Diageo points to an organization that can take on more debt should it need. This is founded on its lower gearing compared to competitors in the industry. Should Diageo not get in to distress and thus lose it’s a- rating, it would be best placed to take on additional debt given its market gearing is 4 percent lower than others in the market. On account of equity maximization, the interest coverage ratio has been established to range between 3.5 and 4.5. Since it was possible for Diageo to adopt a strategy that would result in additional debt thus lowering the debt rating, by not taking the particular strategy it is a pointer to an organization with a conservative capital structure.
- Using the data provided by the simulation model presented in the case and your personal assessment, what capital structure would you recommend to Diageo, more or less debt than it currently has?
From the Monte Carlo simulation, it would be best if Diageo maintained an interest coverage ratio of 4.2. At this point, Diageo is able to benefit from minimal tax bill coupled with expected distress costs. Care should however be taken when considering the simulation. As a tool, it is not a silver bullet since it does miss to capture some of the dynamism of the capital structure. Consequently, it does not take into consideration the ‘year-end zero cash balance’ in addition to inputs that relate to future acquisition. In as much as the trade-off theory has guided Diageo thus far, as an organization, it needs to be cognizant of the its expansion and acquisition plans and thus adopt a strategy that supports the financial flexibility needed. The graph points to a weighted average cost of capital that support the view that Diageo would remain solvent even with additional debt. However, given the inability to quantify distress costs make it impossible to determine the optimal debt to equity ratio. Too much debt will only have the effect of shrinking equity value at a much faster rate. With a forecasted market gearing of 25 percent, Diageo’s is still lower that its competitors. From the case study is it clear that Diageo sees its future in the alcohol and beer industry that could explain why it plans to divest from its package food industry – by selling Pillsbury and Burger King. Given that rating agencies will base their ratings of an organization relative to its industry, it is important to compare with others in the industry – beer and alcohol. Thus studying competition should give a good pointer from which Diageo can compare itself to. As an analysis tool, market gearing ratio is a pointer to the amount of debt as a percentage of cumulative short and long term debt and market value of equity and reveals Diageo has the lowest debt. Allied Domecq is rated by credit agencies as A- despite its market gearing being 29 percent. Additionally, its book gearing is significantly higher than Diageo’s at 88 percent as compared to 59 percent. It would be an educated guess that at this point Allied Domecq has not distress costs. Diageo should maintain the same capital structure it currently has since it keeps it able to take on additional debt should the need arise and at no distress costs.
References
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Chacko, G and Tufano, P (2001) Diageo Plc, Harvard Business School |